Related topics: emerging markets, investing strategy, funds, China, Anthony Mirhaydari
Stocks have bounced back quickly from their mid-March lows. Investors, it seems, just can't be bothered with Moammar Gadhafi's psychosis or irradiated bilge water at Japan's Fukushima Daiichi nuclear plant.
But the real news has been the transition of leadership we've seen: After months of underperformance, emerging market stocks are once again leading the charge. From March 16 to April 4, iShares MSCI Emerging Markets Index (EEM, news) climbed nearly 12% from its low. Compare that with the 6% rise in the Standard & Poor's 500 Index ($INX).
This kind of performance disparity hasn't been seen since late last May, a period that marked the beginning of six months of relative strength for emerging market stocks compared with U.S. equities.
I think we're in the midst of a repeat performance.
Taking their medicine
This is a big deal. Emerging market stocks went from hot to not in a big hurry last year as China, Brazil and other developing economies raised interest rates and drained liquidity to clamp down on inflation. The catalyst was higher prices fueled by robust economic growth and ultracheap cash imported from the United States and Europe.
The measures were harsh. Barclays Capital estimates that bank lending in China is set to fall 32% this year as banks hoard cash. No fewer than eight Asian economies, including South Korea, India and China, tightened monetary policy in March. Brazil raised its policy interest rate from 11.25% to 11.75%.
Anthony Mirhaydari
Investors bailed on concerns that policymakers overseas would tighten too much, strangling their economies and sparking some unholy combination of social unrest and stagflation, just as the Arab Spring has encouraged rebellious youths in and around the Middle East.
For investors, the calculus was simple. It's no coincidence that EEM started badly underperforming U.S. equities in October and November just as the Federal Reserve was preparing to unleash its $600 billion "QE2" money printing operation and the U.S. economy was starting to show new signs of life.
Things are changing now. And that explains the rush of cash chasing emerging market stocks.
The folks at EPFR Global note that emerging market mutual funds just enjoyed their highest weekly inflow since the first week of January, ending the worst period of outflows since the middle of 2008. This suggests that the recent outperformance enjoyed by these stocks is set to continue.
Why?
Problems in the 'emerged' markets
Inflation expectations are on the rise here at home, pushing down consumer sentiment and spending. It seems that "QE3" is off the table, too, with an increasing number of Fed officials expressing anti-inflation sentiments. Merrill Lynch economists just cut their first-quarter U.S. GDP growth estimate to 1.5%, which isn't enough to pull down the unemployment rate. As recently as last month, Wall Street economists were looking for growth as high as 5%.
At the same time, the U.S. government's budget battle and debt problems loom large. Whatever solution politicians in Washington come up with, it's not likely to be good for the economy over the near term. Expect a combination of deep spending cuts and targeted tax increases.
Further, Europe is a mess. Portugal is on the verge of a Greece/Ireland-style bailout as its 10-year government bond yield soars towards 9%. Neither Greece nor Ireland lasted long after crossing the 7% threshold.
The European Central Bank's anti-inflation stance and likely interest rate hike on April 7 is tightening the noose around Portugal's fiscal airway. Portugal is uniquely sensitive to higher interest rates because nearly 100% of its mortgages are floating-rate, unlike the fixed-rate mortgages Americans are accustomed to. Further, 87% of Spain's mortgage debt is floating-rate. If Portugal does down, the contagion will surely spread to its larger neighbor.
Meanwhile, the situation in the emerging market economies is improving.
Inflation risks fading
There is evidence that because of their early attack, price pressures in emerging markets are beginning to ease. Purchasing managers in China have reported a 1% drop in input prices so far this year -- a three-month period that saw a 4.2% average rise over the last five years. Qinwei Wang, a China economist at Capital Economics, believes that the combination of cooling inflation and slowing growth will lead China's policymakers "to feel that pressure for aggressive tightening has declined."
Oil prices are a wild card. Crude oil needs to stay below the magic level of $125 a barrel -- a level I discussed in a recent column. Right now, West Texas Intermediate trades near $109. A lot depends on the success of Libyan rebels in the fight to recapture oil assets on the Gulf of Sidra.
Despite such uncertainties, market participants are beginning to feel that the risks to stocks in emerging economies have been adequately discounted, and they're on the prowl for growth opportunities once again.
